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Profile Your Attitude To Investment Risk Finance Essay

Are you investing a sum of money. Are you willing to take any risk with the capital you are investing. These can be daunting questions especially if you have not done this before and/or have no idea where to look for assistance in helping you make these important decisions.

There two areas you need to consider before investing your money:

Ensure that you have sufficient funds set aside to protect you in the event of an unforeseen emergency, ie repairs to your home or car etc. Typically you should have the equivalent of 3 – 6 months outgoings set aside in an Easy/Instant Access account with a bank or building society. IF this isn't the case, you should make this your priority.

How long do you wish to invest for? Do you have a specific time frame or goal in mind – ie a wedding, school fees, holiday of a lifetime etc.

What is Attitude to Risk?

Once you have the answers to the above 2 questions, it is important that you have a clear understanding of your Attitude to Investment Risk.

There are two ways to think about risk:

Your capacity or ability to take risk. This is all about your financial circumstances and goals. If you have more wealth and can invest over the medium to long term (5 – 10 years), you may be more able to accept a higher degree of risk.

Your attitude or willingness. This is more of a mental approach. Some people may not be able to sleep at night at the thought that their investment can fall in value rather than rise.

How to determine your individual Attitude to Investment Risk

There are a number of ways to assess your attitude to investment risk.

If you don’t feel confident enough to invest your money yourself, Financial Advisers can help you develop your risk profile by completing a detailed Factfind to build up a complete picture of your personal & financial situation. The Factfind should also include an Attitude to Investment Risk questionnaire which the advisor will ask you to complete. All of this information will then be used to determine your Attitude to Investment Risk and the Advisor will use this to advise on the most suitable investments for your money.

It is important that you ask any prospective Financial Adviser about his/her investment experience and qualifications. You should also ask about any potential conflicts of interest the adviser may have, such as receiving commissions from the sales of investment products from certain providers.

You can find a Financial Advisor near to you through Unbiased.co.uk. You should also check that an Advisor is registered to give investment advice by checking their details on the Financial Services Authority (FSA) Register. Further information about choosing a Financial Advisor can also be found on the FSA's MoneyMade Clear website.

If you prefer to research your investments options yourself, you still need determine your Attitude to Investment Risk and you can use an online questionnaire, known as a Risk profiler to do this. The questionnaire consists of a series of short statements, each of which is followed by a scale where you indicate the extent to which you agree or disagree with the statement.

When using a Risk Profiler tool, it is important to bear in mind that the questions are designed according to the established principles of psychometrics, that is, the science of measuring individuals’ attitudes. This means, however, that these questionnaires do miss the personal questions that a financial advisor will ask you during the course of your discussions. Risk Profiler Tools are also unable to take into account any assets and investments that you may already have.

There are free to use Risk Profiler tools available online from many leading banks & financial institutions. Whilst complying with professional standards, many people within the Financial Services industry believe these can be biased towards the provider's own investment funds, which may be overpriced compared to other similar investments available.

An independent Risk Profiler tool may prove a more suitable alternative – i.e. Fina Metrica, which asks more questions and gives a better, independent assessment of your individual risk profile. However, these come at a cost to the user and as a result many people may decide not to use them. This could, however, be a false economy if they give a more unbiased view than the free of use profiling tools.

It is important to remember that if you invest without taking professional advice, you will be responsible for your decision to buy, so if the investment turns out to be unsuitable for you, you will have fewer grounds for complaint.

Definition of Attitude to Investment Risk

Once you have answered all the questions, the Risk Profiling tool will indicate the risk profile that matches your Attitude to Investment Risk.

Risk Profiles fall into different categories and can vary in number depending on the Risk Profiler tool you have used. The main categories are: No Risk/Very Cautious - Low Risk /Cautious - Medium Risk /Balanced – High Risk/Adventurous

The industry standard descriptions of these Risk categories are as follows:

No Risk/Very Cautious

Preserving your capital is the most important factor when you consider your savings. This means that you are more likely to restrict your savings (for growth or income needs) to cash deposits, cash ISAs, interest bearing savings accounts and similar products that also offer ready access to your money and are covered under a depositor protection scheme.

You understand the effects of inflation on your capital (and any interest received) and how this can reduce the real value of your money over time.

Low Risk/Cautious

The opportunity to achieve reasonable returns (for growth or income needs) is important to you but you want to invest in a way that preserves more of your capital if stockmarkets fall. You may have little or no experience in taking investment risks, but accept this may be necessary to achieve returns potentially equivalent to or higher than those available from cash deposits. You understand that this could involve your capital being invested for five years or more with low to medium exposure to stocks and shares and other more riskier investments.

You understand that the value of any investments you make will fluctuate and you might get back less (or more) than you invested (at maturity or earlier).

Medium Risk/Balanced

The opportunity to achieve attractive returns (for growth or income needs) is very important to you but you also want to invest in a way that does not expose all of your capital to more riskier investments. You have some experience in taking investment risks and accept this is necessary to achieve potential returns much higher than those available from cash deposits. You understand that this could involve your capital being invested for five years or more with medium to medium high exposure to stocks and shares and other more riskier investments.

You understand that the value of any investments you make will fluctuate and you might get back less (or more) than you invested (at maturity or earlier).

High Risk/Adventurous

You are an experienced investor and are prepared to take on very high levels of investment risk that offer the potential to achieve exceptional returns. This opportunity to achieve exceptional returns (for growth or income needs) is a key priority for you – even in circumstances where it might pose a significant risk to some or all of your underlying capital. You understand that a high-risk investment could involve your capital being invested for five years or more with maximum (up to 100%) exposure to stocks and shares and other more riskier investments. 

You understand that the value of any investments you make will fluctuate and you might get back much less (or much more) than you invested (at maturity or earlier).

It is important that once the Risk Profiler has confirmed your Attitude to Investment Risk category, you are honest with yourself about your own emotional willingness to accept risk and review how this is reflected in the summary of the Risk category that has been returned, selecting an alternative category if necessary. A good way to test your own emotional willingness to handle risk, is to initially invest with small amounts of money on a monthly basis and increasing the overall amount of money you invest based on the returns you achieve and your appetite for handling greater risk.

If you feel uncomfortable accepting any amount of risk, then investing might not be suitable for yo

How & where do you invest you money?

Having ensured that you have an emergency fund set aside, decided on the amount you wish to invest, the timeframe for that investment and confirmed your Attitude to Investment Risk, where and how do you invest and which asset classes should you invest in?

It is important that you understand the different types of asset classes, the level of risk for each class and how to spread your investment across the asset classes to create a investment portfolio that matches your Attitude to Investment Risk.

There are a number different asset classes to invest in, each of which come with different risks. The four main asset classes are: Cash, Bonds, Property and Stocks & Shares (also known as Equities).

Cash is perceived as the least risky but tends to deliver low returns. However, don't think that that there aren't any risks with cash investments – for example the spending power of your money might fall if inflation is higher than the interest rate you receive. This is known as inflation risk.

Examples of Cash or Cash equivalent investments are: Cash ISA’s, National Savings & Investments (NS&I), fixed notice savings, fixed term bonds and high interest savings

In the 2012/13 tax year, the Cash ISA allowance is £5,640 and you can top up your Cash ISA account on an annual basis every tax year. All gains you make from the interest you’re paid are free of income and capital gains tax.

NS&I is a government backed service for savings and investments, offering a range of products and designed to help people save money. As it’s run by the government, it means that 100% of your savings are fully protected, which is much better than the £85,000 that the UK’s Financial Services Compensation Scheme (FSCS) provides if your bank goes bust.

NS&I offers a range of investment products such as premium bonds and simple cash accounts, children’s savings products. They also sell inflation-linked savings certificates which are quite popular. NS&I generally don’t provide market-beating interest rates, as a rule, on their products but if your risk profile is low then this gives the safety you’re looking for with your cash, this type of investment could be a good option.

Bonds are the next step up on the Investment Risk ladder. Examples of Bond investments are: government bonds or gilts and Corporate bonds. When you invest in a Bond, you are lending money to a government or a company in return for a fixed interest rate for a set period of time after which your money is repaid to you.

This type of investment means putting your money at a greater risk than cash investments. To get the extra reward that these investments can offer, you have to be prepared to accept the risk you could make a loss.

However, Fixed interest investments are are perceived to be the next risk up from cash but should be less risky than equities.

A normal UK gilt could look like this - "Treasury stock 5% 2016." This shows the following:

' the issuer' – Treasury - This is the department that issues the gilt

' the coupon' - 5% - This is the rate of interest to be paid

' the redemption date' - 2016 - This is when the loan is to be repaid

Other governments around the world also issue bonds to raise money. Some are safer than others – bearing in mind governments like the Eurozone countries can get into financial trouble this suggests that placing your money with other national governments can be a higher risk.

Corporate bonds are issued by companies these that are looking to raise capital. This type of investment is seen as riskier than gilts as a rule, as companies have a higher risk of default on debt than governments. Corporate Bonds may offer investors a higher rate of interest for taking on this risk.

Property is the 3rd step up the Risk Ladder.

The three categories of commercial property are:

Retail property – this includes retail warehouses, supermarkets, shopping centres and shops on the high street.

Office property – purpose-built for businesses, these often require services essential to businesses and the installation of specialist services like high speed internet.

Industrial property – like warehouses and industrial estates

Commercial property is an important asset class to consider investing in property can be a way of spreading, or diversifying, the risk in your investment portfolio.

Investing in commercial property, such as offices, warehouses and supermarkets, can produce you a return through rental income and capital growth from the possible any increase to the value of the property.

Property isn't usually linked to other the other assets classes meaning that property values usually move independently of them and isn’t typically affected by what's happening in the stock markets.

However like any other investment the property crash of 2007/08 saw investors lose money, illustrating that investing in property does have risk.

Stocks & Shares (Equities) is the final asset class and considered the most risky.

This is mainly because stock markets around the world can be highly unpredictable. Investing in the home market or UK equities is considered as lower risk than say US equities, while emerging markets these tend to be more volatile (such as India, China or Brazil) these markets and the equities are viewed as the highest risk as you are investing in less well-known companies.

There are two basic types of shares issued by companies that you can purchase:

Ordinary shares

If you purchase ordinary shares, you become a part-owner of the company and this usually entitles you to get dividends. These are a share of the companies' profits that is paid out to shareholders after it has met all of its other obligations and expenses. It is not obligatory that companies pay dividends, and even if they do, they can stop or cut them at any time.

Ordinary shares are voting shares, this means you also get a say on matters relating to the company, this could include voting on director’s fees or agreeing on a takeover.

There are no guarantees with ordinary shares which is a risk so you may not get any share of the profits and, you’re the last in line to be repaid your capital if the company goes bust.

Preference shares

There are no voting rights for these shares. However, as the name suggests, they entitle you to other rights. Preference shareholders usually receive a share of the profits before ordinary shareholders, this is usually limited as defined by the issuing company.

In addition to this, preference shareholders get paid before ordinary shareholders should the company go bust. Preference shares still have risks to your capital investment but not quite so big a risk as ordinary shares but payments are usually less.

The profit from shares comes in two ways, either in dividends and/or capital growth.

Dividends

Companies distribute their profits by dividend payments to shareholders. These payments are usually paid out twice a year.

Dividends are more likely to be paid by longer established larger companies – the dividend pay-out will be dependent on how profitable the company is. 

Smaller companies tend to reinvest their profits to help grow their business so are less likely to pay out a dividend. If a smaller company does manage to successfully expand, the value of your shares could grow and start paying dividends at a later date.

Capital growth

If you sell your shares for a higher price than what you bought them for, this provides you with capital growth i.e. an increase on your initial investment.

The price of your shares can go down as well as up and they are affected by internal and external factors.

Tax on shares

Dividend income

Income from dividends is paid after 10% tax has already deducted, even if you choose to reinvest it or have the dividend paid in shares or cash.

Basic-rate taxpayers have no further tax to pay. But if you pay no tax personally, this tax is still deducted and cannot be claimed back.

Higher-rate taxpayers have to pay 32.5% of the gross dividend, either by self-assessment or by completing a tax return. Highest rate taxpayers pay an extra 42.5%.

Taxation on selling your shares

Currently you are allowed to make a Capital Gain of £10,600 (2012/13 CGT allowance) before tax is payable.

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